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Analysis of Exchange Rate Risk & Hedging Strategies

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Analysis of Exchange Rate Risk & Hedging Strategies Analysis of Exchange Rate Risk & Hedging Strategies - Study on Dutch Listed Firms Author: Akash Kumar (11133317) Contact: [email protected] Supervisor: Prof. Jeroen Ligterink Program: Amsterdam MBA (Full Time – 2016-17) Analysis of Exchange Rate Risk & Hedging Strategies ABSTRACT Currency risk arises from a combination of foreign currency exposure and volatility in foreign currency exchange rate with respect to domestic currency. As the firms may experience considerable exposure to foreign exchange rate risk because of foreign currency based activities and international competition. Many currencies are volatile as they show high fluctuations in the value due to various factors, such as trading speculation, change in global political and economic scenario, policy of central banks and many other factors. To minimize the effect of exchange rate risk, many firms use hedging techniques to over exposed risk, which may help to minimize the effects of exchange rate risk. In this paper, some hedging strategies will be discussed, for minimizing the firm’s exposure due to exchange rate fluctuations and test whether hedging diminishes the firm’s exposure. We analyse the relationship between the change of exchange rate and stock returns of 17 Dutch firms over a period of 10 years (2006-2016). We find that 41% of the firms are significantly exposed to exchange rate risk. We also examined the relationship between the coefficient of exchange rate exposure and foreign currency derivatives used by the firm to hedge the currency exposure. We were not able to any significant relationship between coefficient of exchange rate exposure and foreign currency derivatives. CONTENTS Abstract List of Abbreviations I. Introduction …………………………………………………………………………. 1 A. Background ………………………………………………………………… 1 B. Research Objective …………………………………………………………. 4 II. Conceptual Framework : Theory Review, Tools & Framework ……………………. 7 A. Foreign Exchange Risk ……………………………………………………... 7 B. Type of Foreign Exchange Risk ……………………………………………. 7 C. Factors Affecting Exchange Rate Fluctuations ……………………………... 9 D. Hedging ……………………………………………………………………. 10 E. Hedging Instruments ………………………………………………………. 12 a. Currency Forwards ………………………………………………… 12 b. Currency Futures …………………………………………………... 13 c. Currency Options ………………………………………………….. 13 d. Currency Swaps …………………………………………………... 14 F. Literature Review ………………………………………………………….. 15 III. Framework ………………………………………………………………………… 18 A. Exchange Rate Fluctuations and Stock Return …………………………..... 19 B. Currency Derivative and Exchange Rate Exposure ……………………….. 21 C. Empirical Findings ………………………………………………………… 21 IV. Managerial Implications …………………………………………………………... 25 V. Conclusion ……………………………………………………………………….... 29 VI. References …………………………………………………………………………. 31 LIST OF ABBREVIATIONS / KEY WORDS Forex / FX – an abbreviation of ‘foreign exchange’ Euro (€) – Currency of 19 Eurozone countries USD (US$) – United States Dollar, currency of U.S. Foreign Exchange Fluctuation – The change in value of one currency with respect to another currency. Domestic currency – the currency issued for use in a particular jurisdiction. For example, for Netherlands it would be Euro Forward exchange contract – an agreement to exchange one currency for another currency on an agreed date (for any date other than the ‘spot’ date) Hedging – A transaction which protects an asset or liability against a fluctuation in the value of foreign currency. option – A derivative instrument. A call option is in the money if its strike price is below the current spot price. A put option is in the money if its strike price is above the current spot price. Spot rate – Arrangement to exchange currencies in two working days. Bid – the rate at which a dealer is willing to buy the base currency. Analysis of Exchange Rate Risk & Hedging Strategies I. Introduction A. Background: An exchange rate of two currencies is the rate at which one currency can be exchanged for another currency or simply the value of one country’s currency with another country’s currency. Currency trading has been prevailing since the ancient times. During the early time, Byzantine government kept a monopoly on the exchange of currency (Hasebroek, 1933: 155-157). The trade was taking place in the ancient world and different kingdoms used different currency (mostly made of gold or silver), the value of this currency was determined by the amount of gold/silver in one kingdoms coin with respect to another kingdom’s. The coin with less gold was cheaper, hence more coins had to be paid for the lower value coins. During the 15th century, Italian Banks, such as those run by the Medici family, started to open foreign branches to effect payments and currency exchange for their clients (Smith, Walter, DeLong, 2012: 3). In order to facilitate currency exchange and international payments Nostro and Vostro bank accounts were started during this time (Roover, 1999: 130). These accounts are even used today by firms doing international transactions. During the modern era, Bretton Woods Accord was signed in 1944. Under this system, each country was obligated to maintain its currency fluctuations within a range of ±1% from the currency’s par exchange rate. The member states were required to control their country’s currency within the ±1% parity by intervening in their foreign exchange markets. This gave rise to pegged rate currency regime, wherein different currencies were pegged to dollar and the dollar was linked to gold at the rate of $35 per ounce. Bretton Woods system ended in 1971, after the United States unilaterally terminated convertibility of the US dollar to gold. This was the starting of free floating exchange rate regime, wherein most of the currencies were determined by the market conditions. The central bank could only control their local currency rate by intervening in the market (by purchasing or selling the currency). Page | 1 Analysis of Exchange Rate Risk & Hedging Strategies Exhibit 1 - Timeline of Foreign Exchange Evolution Byzantine governtment Birth of keeps a modern monopoly on First Forex foreign currency Market is exchnage in Start of exchnage maintained in the form of Bretton •4th Century Amsterdam Gold standard Woods System AD •18th Century •1880 •1944 Medici family Foreign integration of open Banks to exchange was Forex trrade in exchange successfully financial currencies completed by functioning of •15th Century financial London agents of •1928 England and Holland •1704 Since the collapse of Bretton Woods system in 1971, many currencies became free floating and in the present era of globalization, firms have businesses in many different countries, and thus these firms have exposure to different currencies. The multinational corporations are exposed to risks of currency exchange rate fluctuation with respect to the domestic currency. As firms have diversified business interests in different countries and currencies, the exchange rate fluctuation can greatly affect a firm’s activities, such as its cash flows and firm value. The adoption of Euro in 1999, eliminated currency exchange rate between some countries. The Netherlands being a part of Europe Monitory Union has been using Euro since, 2002. The creation of single currency and formation of a monetary zone helped to provide monetary stability in the countries of Euro zone and move towards a single market. The formation of EU was motivated by several factors. Firstly, formation of EU has ruled out unfair competition practices by EU countries, which devalued their currencies vis-à-vis other member countries. Secondly, the creation of a single market (euroland) should help to reduce the exposure of euroland countries to international monetary instability (Fouquin, Malek, Mansour, Mulder, Nayman & Sekkat, 2001). Currently 19 out of the 28 Euro Zone member states are using Euro as their currency. This is beneficial for intra Europe trade, but there are total of 180 (approximate) different currencies Page | 2 Analysis of Exchange Rate Risk & Hedging Strategies worldwide, many of which may expose a firm to exchange rate fluctuations. The single currency has helped to eliminate the exchange rate fluctuation risk within the Euroland countries, but the single currency is still vulnerable to the exchange rate fluctuations of the other major currencies, such as the US Dollar, Pond Sterling, Yen and currencies of other major trading partners(countries). Exchange rate fluctuations have a substantial effect on firms. The fluctuation of foreign exchange rates affects both the cash flow and discount rate and hence the value of the firm. We will try to analyze the impact of exchange rate on the firm’s value by means of impact of foreign currency exchange rate on the share price of the firm. Exposure represented the sensitivity of the value of the firm to the exchange rate movements and can be measured by the regression coefficient of the change in the value of firm on the change in exchange rate (Jorian, 1990). Some of the most common factors which affect the value of a country’s currency are: (Which in case of our study are factors faced by Euro Monitory Union combined and as guided by ECB): a. Current account deficit of the country. b. Public debt of the country. c. Political stability and economic performance. d. Rate of inflation for the country e. Interest rates The exchange rate risk is a mixture of exposure to a currency and its volatility. As the firms may experience considerable exposure to foreign exchange rate risk because of foreign currency based activities
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